The Function of Profits

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By their very nature profits indicate the desirability of a particular product or service.  They should be seen as an indicator that a transition is taking place — from a state where a product or service was less desirable (or non-existent) to a state where the industry is oversaturated (too many companies and individuals working in the industry).

The transitory nature of profits can be seen as follows.  As the desirability of a product or service increases, individuals are willing to pay more for it, and as profit potential for the industry is higher, individuals are drawn into the industry; in effect the demand (willingness to buy at higher prices) creates an incentive for individuals to meet the requirements of the majority (they desire more of a particular product or service).  As more individuals are drawn to the industry seeking profits, competition increases and the price is driven down once the demand of the majority is exceeded.

A price movement up means the majority has voted (see The Questionable State—and Abusive Use—of Economics) for more production in the industry.  In this way profits align the desires of a minority with the majority; both of their desires are met — the minority (those in the industry) receive higher profits and the majority (the constantly voting population) receive more of the desired product or service that they are willing to pay more for.  The voting population has effectively encouraged more suppliers, competition, and output from existing companies, by increasing their demand (i.e. offering to pay more for the product or service).

The tendency for individuals to think that profits are not transitory often leads to complacency when vigilance should actually be pursued.  By their very nature profits encourage competition — causing future profits to be slower unless new ideas are developed or efficiency is pursued.

As a visual concept, imagine a balance that has a weight added to it.  The balance adjusts from the old state (without the weight) to the new state (with the weight).  In this example, the motion of the balance is similar to profits; the balance moves (profit incentive is created) as it transitions from the starting state (before individuals demanded more of a particular product or service) to the ending state (the demand of individuals is met based on the majority vote).  This is the transitory effect of profits; they are an incentive from the majority to draw more labor to a desirable industry (or draw more production from the industry) to meet demand until prices are reduced — which then reduces profits.  The balance moves back and forth, each change based on the desires of the majority, each change causing an adjustment (seen through profits) that is merely a sign of a temporary transition.

The function of profits, finally, is to put constant and unremitting pressure on the head of every competitive business to introduce further economies and efficiencies, no matter to what stage these may already have been brought.  In good times he does this to increase his profits further, in normal times he does it to keep ahead of his competitors, in bad times he many have to do it to survive at all.  For profits may not only go to zero, they may quickly turn into losses; and a man will put forth greater efforts to save himself from ruin than he will merely to improve his position. – Henry Hazlitt (Economics in One Lesson)

And because of the competitive nature within those industries that have a profit potential (ones that have seen an influx of labor to meet demand), it is extremely difficult for an investor to profit by investing in an entire sector.  However, the exception would be a case where the price of an entire sector is mistakenly undervalued/under-appreciated; in this case patience could reward an investor if future profitability occurs — yet even in this case competition inhibits the returns (as some companies will inevitably be outperformed).  The close competition in the sector necessitates that there will likely only be some companies that succeed.

“Contrary to popular impression, profits are achieved not by raising prices, but by introducing economies and efficiencies that cut costs of production.  It seldom happens (and unless there is a monopoly it never happens over a long period) that every firm in an industry makes a profit.  The price charged by all firms for the same commodity or service must be the same; those who try to charge a higher price do not find buyers.  Therefore the largest profits go to the firms that have achieved the lowest costs of production.  These expand at the expense of the inefficient firms with higher costs.  It is thus that the consumer and the public are served.” – Henry Hazlitt (Economics in One Lesson)